Might Financial Engineering Extend The Bull Market?

For both investing and the economy, cost of capital and return on invested capital (ROIC) are vital concepts. Generally speaking, investment capital will seek its highest return. This is partly what drives stock prices but it also is an important element in private investments and capital spending decisions by businesses.

The past several years have witnessed financial market anomalies not seen in many decades. One of those anomalies currently is the unusually wide disparity between the cost of debt capital and the cost of equity capital. Because of the long decline in interest rates, the cost of debt capital is now very low relative to the cost of equity capital.

Anomalies like this present capital opportunities. Specifically in this case, an arbitrage opportunity exists in which low cost debt can be used to boost shareholder returns (ROIC). How does this work? Say, for example, a large company has a current cost of debt capital of 2% and a cost of equity capital of 8-9%. It might make financial sense for this company to take on debt and use that capital to reduce equity capital through share buybacks. The result of this is higher ROIC.

The potential for exploiting the current debt/equity arbitrage has positive implications for the stock market and the economy. Why? First, it means that capital heretofore not invested in equities can come into the market via acquisitions and share buybacks; and second, capital is allocated more efficiently in the economy, an important benefit.

History repeats itself. We saw something like this in the early and mid-1980s. As interest rates (cost of debt capital) came down during the 1980/81 recession, it allowed strong companies to take on debt and acquire undervalued companies through leveraged buyouts (LBOs). This “financial engineering” process is occurring again and could be further fueled by this debt/equity arbitrage.

From a financial planning perspective, to the extent this arbitrage opportunity can continue over the next year or two, it reflects positively on stocks as an important vehicle for enabling clients to grow their financial assets, meet long-term financial goals, and keep up with inflation.